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"Foreign critics should not worry about ‘my’ rule"

Author: Paul Volcker, International Council Member, Belfer Center for Science and International Affairs

I confess total surprise about the complaints by some European and other foreign officials about the restrictions on proprietary trading by American banks embedded in the Dodd-Frank Act – now dubbed the “Volcker” Rule.

It made me think – think all the way back to my years in the US Treasury and Federal Reserve, when the Glass-Steagall Act was in full force. The practical effect was to ban all securities trading by US banks – not just “proprietary” trading, but also “market making” and “underwriting” (except in US government and certain municipal securities). I do not recall – and I am morally certain it never happened – receiving a single complaint that US law was discriminatory, that it damaged other sovereign debt markets or that it limited the ability of foreign governments to access capital markets

There is a certain irony in what I read. In Europe, there are plans to introduce a financial transaction tax, justified in part by officials because it puts “sand in the wheels” of overly liquid, speculation-prone securities markets. For reasons analogous to those behind the Volcker Rule, the UK is planning to “ring fence” trading and investment banking from retail banking, creating airtight subsidiaries of larger organisations. The commercial banks responsible for what are deemed essential services to the economy will be insulated from all trading and only then will they be protected by the official safety net of access to the central bank, deposit insurance and possible assistance in emergencies.

That approach, as a matter of regulatory philosophy and policy, resembles the seemingly less draconian US restrictions on proprietary trading.

The simple fact is that Dodd-Frank specifically permits both “market making” in response to customer needs and “underwriting”. No doubt US banks will, upon request, be happy to provide those services to the UK and other governments. They can continue to purchase foreign sovereign debt for their investment portfolios – should I say à la MF Global? What would be prohibited would be proprietary trading, usually labelled as “speculative”. How often have we heard complaints by European governments about speculative trading in their securities, particularly when markets are under pressure?

Is there really a case that proprietary trading is of benefit to the stability of commercial banks, to their risk profile and to their compensation practices and desirably fiduciary culture? I think not, and we need to look no further than Canada for a system in which its large banks have been much less committed to proprietary trading than a few US giants. In any event, there are and should be thousands of hedge funds and other non-bank institutions ready, willing and able to undertake proprietary trading in unrestricted securities in large volumes. The point is that those traders should not have access to the taxpayer support implicit in the safety net of commercial banks.

In addressing liquidity, can it really be of concern that some of the largest banks in Europe, in Japan, in China and indeed in Canada cannot maintain effective markets in their own sovereign debt? US chartered commercial banks could remain participants “making markets” for their customers wherever they are.

Let’s get serious.

National regulatory (and at least as important, accounting and auditing) authorities should, to the extent that it is practical, seek common understanding and common approaches. In the past, I participated in that process, helping to initiate the effort to achieve common capital standards for banks. I am today encouraged by efforts under way by the US, British and other authorities to reach the needed degree of consensus with respect to resolution authority – in plain English how practically to end the “too big to fail” syndrome. This is really complex. The major banks are international and managing their orderly merger or liquidation will necessarily involve co-operation among jurisdictions. That is a key challenge, arguably the most important one for banking reform. It needs to be dealt with.

Meanwhile, let us not be swayed by the smokescreen of lobbyists dedicated to protecting the interests of some highly compensated traders and their risk-prone banks.

US regulators are now considering what adjustments should be made in their preliminary rules with respect to market making and proprietary trading, while hopefully reducing the inevitable complications imposed by the very complexity of modern finance. I regret that the effect, if not the intent, of much of the lobbying has been to add complications rather than to clarify the principles involved. As with any new regulation, there will be, with experience, opportunities to deal with unnecessary frictions or unintended consequences. But I certainly take comfort with the stated confidence of the authorities that the rule adopted will be both workable and effective.

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